Finer Nuances Of Financial Planning Aspects - IV : Portfolio Construction

So far we have understood how to set goals, cover for risks and put a framework in place for our portfolios. The final step is to fill out that framework with the right products. This is where portfolio construction comes in. What is portfolio construction aimed at? What is most effective way to construct a portfolio? And what role do taxes play in this exercise? Let's find out.

What Portfolio Construction Is Not

Portfolio construction is mostly perceived as the exercise of picking and holding the best performing investment products. This ties in with the Enterprising Approach to investment management. But trying to do things this way only complicates things. This is because adhering to the enterprising approach demands the following from investors.

Most of us cannot meet these demands. Some of us may have the time and some knowledge. This knowledge is likely to have been gained through a basic level of research. Once we do some basic research about a product we feel like we have understood it well. But our knowledge is likely to pertain to selected aspects of the product at best.

We may also lack the insight to go with the knowledge. Knowledge is mere collection of information. Insight is knowing how to apply and draw inferences from the available information. Different people may have knowledge of different aspects of the same product. Therefore their perceptions of the same product are likely to be very different. But neither of them are likely to have a complete understanding. This is similar to a group of blind people touching an elephant.

Also the objective of a portfolio focusing on product selection is to beat the market return. Doing this requires investors to accurately predict market outcomes. The market for any asset class is a system of human beings coming together to transact products within the concerned asset class. To predict the outcome of a system, one must understand its behaviour. So beating the market essentially requires investors to understand and predict human behaviour. Most of us know and understand ourselves well. But none of us can accurately predict our own behaviour. Therefore we have no chance of predicting the behaviour of lakhs of other investors around us. Therefore portfolios constructed based on product selection are likely to yield poor long term results.

The Essence Of Effective Portfolio Construction

Effective portfolio construction aims to facilitate broad based exposure across asset classes for each goal. This prepares the investor for the widest possible set of outcomes. It therefore allows them to limit uncertainty while maintaining substantial potential for gains. Portfolio construction is therefore aimed at effective risk management. Investors must therefore understand the nature, return characteristics, risks and interrelationships inherent to various asset classes. An understanding of base rates on investing would help in this regard.  

The Concept Of Base Rates

A base rate is a statistic that provides insights into the likelihood of a particular outcome. Base rates may also help point towards the most likely outcome to an exercise. They are derived from large volumes of historical data and empirical evidence. They therefore provide a scientific backdrop against which to make decisions. They therefore improve the quality of decisions made. Base rates on investing offer valuable insights on the behaviour and expected return from various asset classes. It is therefore important for investors to understand them before picking products for their portfolios. 

Let us now understand the most important base rates on investing and their implications. SPIVA (S&P Indices Versus Active) Scorecard reports from across the world have shown that 71% of actively managed equity funds have underperformed their benchmarks as of year end 2024. It also shows that 59% of stocks failed to beat their benchmarks. This is true all across the world. This implies that active management strategies are unlikely to beat the market over the long term. 

Another vital base rate is found in the Quantitative Analysis of Investor Behaviour (QAIB) report. It is released annually by Dalbar Inc., an independent investment research firm. The study observes investor behaviour and reasons for underperformance since 1994. The most recent edition of the report shows that the average individual investor has underperformed the market by an annualised 1.11% over the 20 year period ended December 2024 (January 2005 - December 2024). This is laid out in the below graphic taken from the report.

This shows that most investors who try to beat the market are often their own worst enemies. Their underperformance is primarily attributed to attempts made to time the market and chase performance. Other reasons include a lack knowledge and behavioural discipline. This causes investors to deviate from the plans set for them.

The base rates from the SPIVA and QAIB reports carry three major implications for investors :  

1.  Investor behaviour has a much greater impact on investment returns relative to product selection. 

2.  Investment products and financial plans are only as good as the investor's ability to stick to them over long periods. 

3.  Superior product selection and investment returns cannot compensate for erroneous or inadequate financial planning. Product selection would be effective only when it is done within the context of a well conceptualised financial plan.

Investors are therefore better served not putting too much effort into product selection. Passive products that provide diversified exposure at low costs would be enough for most portfolios. The focus must rather be on having a long term view and maintaining behavioural discipline. 

What Role Do Taxes Play?

Taxes are an unavoidable cost that all investors must pay on their investments. Knowledge of the tax implications inherent to their products would help investors reduce their tax outgo. This would lead to better outcomes without increasing risk. But it must be remembered that tax implications must not form the basis on which investment decisions are made. They can at best serve as a guideline. Keeping this much in mind would help us construct portfolios effectively.